DAMODARAM SANJIVAYYA

NATIONAL LAW UNIVERSITY

SABBAVARAM, VISAKHAPATNAM, A.P., INDIA

REMEDIAL CLASSES

NAME OF THE FACULTY:

Asst. Professor Abhishek Sinha

Name of the Candidate:

Aaka Azim Khan
Roll No: 23LLB001
Semester:II

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 INDEX

 Topic 1 : Demand
 Topic 2: Taxation

 Topic 3: Fiscal and Monetary Policy

 Topic 4: Markets

 Topic 5: Theory of Production

 Topic 6: Public Finance

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 TOPIC 1 – DEMAND
Introduction

The willingness to have something can be called as desire. Human beings have unlimited
desires. We are always striving for better things in life. We want a high-end phone, best
education, international holidays, dinner at five-star hotels, swanky cars and bikes, etc.
However, these are merely desires. In order to acquire all of this, we need to have the ability to
pay and even when we have the ability to pay, we need to have the willingness to spend. In
short, a desire or wish can become demand only when the person desiring the product has the
ability and willingness to pay for product.

Meaning of demand

1) In ordinary language, demand means a desire.

2) Desire means an urge to have something.

3) In Economics, demand means a desire which is backed by willingness and able to pay.

4) Eg: if a person has the desire to go on a vacation to Mauritius, but does not have the money
to go there, then it will simply be a desire and not a demand in economic sense.

5) Thus, demand is an effective desire. All desires are not demand

Demand Desire + Ability to pay + Willingness to spend

6) Utility is the basis of demand. Utility may generate desire to have a particular commodity,
but utility on its own cannot generate demand for the commodity.

7) Demand analysis is concerned with consumer behaviour.

8) Demand is a micro economic concept while aggregate demand is a macro economic concept.
Aggregate demand refers to the total amount of sales proceeds which an entrepreneur actually
expects from the sale of output produced at a given level of employment during the year.

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Definition of Demand

According to Benham, "the demand for anything at a given price is the amount of it,which will
be bought per unit of time at that price."

Thus, the following are the features of demand:

1) Demand is a relative concept.

2) Demand is essentially expressed with reference to time and price.

Types of Demand

1. INDIVIDUAL DEMAND

Individual demand is the quantity of a commodity demanded by an indivi (single) consumer

at a given price during a given period of time.

2) MARKET DEMAND

Market demand is the total demand for a commodity by all consumers at a ale price during a
given period of time.

3) JOINT DEMAND OR COMPLEMENTARY DEMAND

When two or more goods are demanded jointly to satisfy one single want, it is known as joint
or complementary demand. E.g. To satisfy the need of making tea, we need water, tea powder,
sugar and milk. Thus, we can say that there is joint demand for these goods,

Other examples: Car and petrol, pen and refill, mobile and charger etc.

4) COMPOSITE DEMAND

The demand for a commodity which can be put to several uses is known as composite demand.
In other words, it refers to the demand for a commodity which can be used to satisfy two or
more wants. Eg.: Electricity can be used to satisfy the want of watching TV, using the washing
machine, charging your mobile etc.

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 5)COMPETITIVE DEMAND

When two or more commodities can be used alternatively to satisfy the same want, then such
goods are said to be substitutes for each other. Competitive demand refers to the demand for
those goods which are substitutes for each other. Eg: Tea or coffee, sugar or jaggery, Pepsi &
Coke, Surf Excel & Tide etc.

6) INDIRECT/ DERIVED DEMAND

The demand for goods which are needed in order to produce finished goods is called indirect
demand, Indirect demand is also called as derived demand. It is the demand for producer's
goods, All factors of production have indirect demand. EgDemand for land, labour, capital etc.
is derived demand.

7) DIRECT DEMAND

The demand for goods which satisfy the wants of consumer directly is called as direct demand.
All finished goods or consumption goods have direct demand. E.g. Demand for food, clothes
and house are examples of direct demand.

Determinants of demand

1) Price of the commodity

2) Price of substitute goods
3) Price of complementary goods
4) Income
5) Nature of product
6) Overall size of population
7) Tastes, Habits and Fashion
8) Level of Taxation
9) Advertisement
10) Expectation about future prices

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 Topic 2 - Taxation

Taxation is a fundamental aspect of modern economies, serving multiple purposes beyond

revenue generation. It influences economic behavior, allocates resources, and redistributes
income. Understanding the principles and effects of taxation is essential for policymakers,
businesses, and individuals alike.

Introduction to Taxation

Taxation is the process by which governments impose charges on individuals and entities to
finance public expenditures. Taxes can be levied on income, consumption, wealth, and various
transactions. The primary objectives of taxation include:

Revenue Generation: Taxes provide governments with funds to finance public goods and
services, such as education, healthcare, infrastructure, and defense.

Redistribution of Income: Taxation can be used to redistribute wealth by imposing higher

taxes on high-income individuals and providing benefits or transfers to low-income
households.

Economic Stabilization: Tax policy can be utilized to influence aggregate demand, address
market failures, and promote economic stability.

Regulation: Taxes can incentivize or discourage certain behaviors, such as encouraging

investment in renewable energy through tax credits or discouraging consumption of harmful
goods like cigarettes through excise taxes.

Types of Taxes

Tax systems vary across countries and can include a combination of different tax types. Some
common types of taxes include:

Income Taxes: These taxes are levied on individuals and businesses based on their earnings.
They can be progressive, proportional, or regressive depending on how the tax rate changes
with income level.

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Corporate Taxes: Taxes imposed on the profits of corporations. Corporate tax rates can
influence business decisions regarding investment, hiring, and location.

Sales Taxes: Also known as consumption taxes, these are levied on the purchase of goods and
services. They can be applied at the point of sale (e.g., retail sales tax) or included in the price
(e.g., value-added tax).

Property Taxes: Taxes assessed on the value of real estate properties. Property taxes are a
significant source of revenue for local governments and are used to fund public services such
as schools and infrastructure.

Excise Taxes: These are taxes levied on specific goods, such as tobacco, alcohol, gasoline, and
luxury items. Excise taxes are often used to discourage consumption of harmful or nonessential
products.

Capital Gains Taxes: Taxes imposed on the profits from the sale of assets such as stocks,
bonds, real estate, and artwork. The taxation of capital gains can influence investment decisions
and asset pricing.

Payroll Taxes: Taxes withheld from employees' wages to fund social insurance programs such
as Social Security and Medicare. Employers also contribute to payroll taxes on behalf of their
employees.

Economic Effects of Taxation

Taxation has various economic effects that can influence individual behavior, resource
allocation, and overall economic performance. Some of the key economic effects of taxation
include:

Incentive Effects: Taxes can alter incentives for work, saving, investment, and consumption.
High tax rates on income and capital gains may reduce the incentive to work and invest, while
tax incentives such as deductions and credits can encourage certain behaviors, such as
homeownership or charitable giving.

Deadweight Loss: Taxes can create inefficiencies in the economy by distorting market prices
and reducing consumer and producer surplus. Deadweight loss occurs when the tax burden
exceeds the revenue generated, leading to a net loss of welfare.

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Incidence: The incidence of taxation refers to who ultimately bears the economic burden of
the tax. While taxes are typically imposed on individuals or businesses, the actual burden of
the tax may be shifted to consumers (in the form of higher prices), workers (in the form of
lower wages), or shareholders (in the form of lower returns).

Tax Avoidance and Evasion: Individuals and businesses may engage in tax planning strategies
to minimize their tax liability, such as exploiting loopholes, shifting income to low-tax
jurisdictions, or engaging in illegal tax evasion activities. Governments employ various
measures to combat tax avoidance and evasion, including enforcement efforts, anti-avoidance
legislation, and international cooperation.

Macroeconomic Effects: Tax policy can have significant macroeconomic implications,

affecting aggregate demand, economic growth, and inflation. Changes in tax rates and
structures can influence consumption, investment, and savings behavior, which in turn impact
overall economic activity.

Tax Policy Considerations

Designing effective tax policies requires careful consideration of various economic, social, and
political factors. Some key considerations in tax policy formulation include:

Equity: Taxation should be equitable and fair, with the burden distributed according to
taxpayers' ability to pay. Progressive tax systems, which impose higher tax rates on higher
incomes, are often considered more equitable than regressive or proportional systems.

Efficiency: Tax systems should minimize economic distortions and deadweight loss while
raising sufficient revenue to fund public expenditures. Broad-based taxes with low rates are
generally more efficient than narrow-based taxes with high rates.

Administrative Complexity: Tax systems should be simple, transparent, and easy to

administer to minimize compliance costs and administrative burdens for taxpayers and tax
authorities.

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Economic Growth: Tax policies should be designed to promote long-term economic growth
and competitiveness. Lowering tax rates on savings, investment, and entrepreneurship can
encourage productivity and innovation.

Revenue Adequacy: Tax revenues should be sufficient to finance essential public services and
avoid excessive government deficits or debt accumulation. Balanced budget principles or fiscal
rules may be implemented to ensure fiscal sustainability.

Effects of taxation on production Main effects of taxation on production are:

Ability to work, Save and Invest: Imposition of taxes reduces disposable income, more bitterly
of the poor section, their purchasing power and ability to acquire necessities, comforts and
luxuries. This reduces their consumption and therefore the ability to work and save. Investment
is a function of saving potential and the resources for investment are curtailed to some extent
with the increase in taxation.

Willingness to Work, Save and Invest: The effects of taxation on people’s willingness to
work, save and invest are partly due to monetary burden of the tax and purity due to the
psychological state of the tax payers. Willingness to work, save and invest is also affected by
the psychology of tax-payer. Taxpayers have a feeling that every tax is a burden. This
psychological state of mind of the taxpayers has a disincentive effect on the willingness to
work, save and invest. Net effect will depend upon their elasticity of demand for income. Elastic
demand will reduce the willingness to work, save and invest.

Effects of Taxation on Allocation of Resource: By diverting resources to the desired

directions, taxation can influence the volume or the size of production as well as the pattern of
production in the economy. It may, in the ultimate analysis, produce some beneficial effects on
production. High taxation on harmful drugs and commodities will reduce their consumption.
This will discourage production of these commodities and the scarce resources will now be
diverted from their production to the other products which are useful for economic growth.

Similarly, tax concessions on some products are given in a locality which is considered as
backward. Thus, taxation may promote regional balanced development by allocating resources
in the backward regions.

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Conclusion

Taxation is a complex and multifaceted aspect of economic policy that plays a crucial role in
shaping economic outcomes and societal welfare. Understanding the principles and effects of
taxation is essential for policymakers, economists, businesses, and individuals to navigate the
challenges and opportunities of the modern tax landscape. By considering equity, efficiency,
simplicity, growth, and revenue adequacy, policymakers can design tax policies that promote
economic prosperity and social justice.

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 Topic 3: Fiscal and Monetary Policy

Monetary policy and fiscal policy are the two most widely recognized macroeconomic tools
used to manage or stimulate a nation's economy. Monetary policy refers to actions that central
bank of a country takes to pursue macroeconomics objectives such as price stability, maximum
employment and stable economic growth. Monetary policy is primarily concerned with the
management of interest rates and the total supply of money in circulation and is generally
carried out by central banks. In contrast, Fiscal policy is a collective term for the taxing and
spending actions of governments. Monetary policy aims at influencing the economic activity
in the economy mainly through two major variables, i.e., (a) money or credit supply, and (b)
the rate of interest.

Active and Passive Monetary Policy

Depending on its responsiveness, a policy is said to be active or passive. Policy rule is said to
be active if it responds strongly while it is said to be passive if it responds weakly. Under an
active monetary policy, a central bank uses its discretion to set monetary policy in response to
changing economic conditions. Active monetary policy grants central Bank the flexibility and
discretion to act based on its assessment of the nation’s economy. Hence, active policy allows
the central bank to moderate economic fluctuations that could create instability.

Monetary policy is said to be passive, when the central bank reacts only weakly to
macroeconomic changes in a country. It follows a predetermined set of rules that are not altered
in response to economic changes. A rule requiring a 1 percent cut in short-term interest rates
for every 1 percent drop in aggregate economic output, as measured by the inflation-adjusted
gross domestic product, is an example of passive monetary policy based on predetermined rules
rather than the discretionary actions of policy.

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Objectives of Monetary Policy

The objectives of monetary policy refer to its goal such as reasonable price stability, high
employment and faster rate of economic growth. Four most important objectives of monetary
policy are the following:

1. Stabilising the Business Cycle: Monetary policy has an important effect on both actual
GDP and potential GDP. Industrially advanced countries rely on monetary policy to
stabilise the economy by controlling business. But it becomes impotent in deep recessions

2. Reasonable Price Stability: Price stability is perhaps the most important goal which can
be pursued most effectively by using monetary policy. In a developing country like India
the acceleration of investment activity in the face of a fall in agricultural output creates
excessive pressure on prices. The food inflation in India is a proof of this. In such a
situation, monetary policy has much to contribute to short-run price stability.

3. Faster Economic Growth: Monetary policy can promote faster economic growth by
making credit cheaper and more readily available. Industry and agriculture require two
types of credit—short-term credit to meet working capital needs and long-term credit to
meet fixed capital needs.

4. Exchange Rate Stability: In an ‘open economy’—that is, one whose borders are open to
goods, services, and financial flows— the exchange-rate system is also a central part of
monetary policy. In order to prevent large depreciation or appreciation of the rupee in terms
of the US dollar and other foreign currencies under the present system of floating exchange
rate the central bank has to adopt suitable monetary measures.

Target of Monetary Policy

Monetary Policy target is a rule according to which the central bank manages monetary
aggregates as operating and/or intermediate target to influence the ultimate Monetary Policy
objective. The targets are to be changed by using the instruments such as variation in the bank
rate, the repo rate and other interest rates, open market operations (OMOs), selective credit

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controls and variations in reserve ratio (VRR) to achieve the objectives. The following points
highlight the main targets of monetary policy.

1. A stable price level: One of the most popular views regarding the aim of monetary
policy is that the value of money should be kept stable. A stable price level is advocated because
the change in the value of money affects different persons differently and because such changes
are likely to have various undesirable effects on the economy.

2. A gently rising price level: Some writers hold the view that monetary policy should
aim at maintaining a gently (i.e., slowly) rising price level Thus according to Keynes, in a
society having unemployment a gently rising price level may be a better monetary policy than
absolute price stability because it provides incentive to the producers, with the result that the
volume of employment and income increases.

3. A gently falling price level: An opposite school of thought advocates a slowly falling
price level as the aim of monetary policy. Thus, according to Dennis Robertson, in a progressive
economy a gently falling price level confers greater benefits upon the fixed income-earners.

4. Neutral money: It has been suggested that the central bank should establish what is
called a ‘neutral money’. It means that money should mere y perform the passive functions of
acting as the medium of exchange and the unit of account, without having no dynamic functions
which affect the economy. But, the objective of neutral money is not capable of wide practical
application.

5. Exchange stability: It is also suggested that the monetary policy should aim at
maintaining stability in rate of exchange, as fluctuating exchange rates introduce uncertainty
into foreign trade. But it has been pointed out that exchange stability in some circumstances
may also lead to instability in the domestic price level.

6. Avoidance of cyclical fluctuations: It is also suggested that the monetary policy should
be directed towards the elimination and control of business cycle fluctuations. But it has been
found that monetary policy alone cannot achieve this goal.

7. Full-employment and economic growth: By far the most popular and accepted aim
of the monetary policy is the realisation of full employment and rapid economic growth.

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According to Keynes, a cheap monetary policy, coupled with deficit spending through the
creation of new money, may promote economic growth.

Rule Versus Discretion in Monetary Policy

Economists broadly categorize policy-making frameworks as either rules or discretion. In a

rules framework, policy responses must follow a pre-specified plan. In the context of monetary
policy, a ruled based policy gives a central bank a strict set of guidelines that dictate its future
actions. For example, a rule-based policy could require a central bank to undertake
expansionary or contractionary policies to maintain a particular price level. A rule involves the
exercise of control over the monetary authority in a way that restricts the monetary authority’s
actions. Under the rule framework policy-makers may be forced to pursue the same course of
action in all circumstances or may direct policy-makers to respond to different circumstances
in different pre-determined ways. The common denominator is that rules are supposed to
constrain policy-makers’ actions in advance.

In a discretionary framework, policy-makers have wide latitude to design the best policy
response for the given circumstances. In the flooding example, discretion means that
policymakers are free to craft a new disaster-relief policy in each period. In monetary policy,
discretionary policymaking corresponds to the central bank seeking to influence or respond to
momentary fluctuations in unemployment and inflation without a long-term strategy. The
changes in interest rates undertaken by RBI are examples of discretionary monetary policy.
Under discretion, a monetary authority is free to act in accordance with its own judgment. For
example, if legislation directed the RBI to do its best to improve the economy’s performance
and gave the monetary authority the instruments that it has, the RBI would have a discretionary
monetary policy.

Time-inconsistent and Time-consistent policy

Time-inconsistency describes situations where, with the passing of time, policies that were
determined to be optimal yesterday are no longer perceived to be optimal today and are not
implemented. A time-inconsistent policy may make the public happy in the short run but will

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ultimately fail to produce the long-run policy goal. A policy lacks time consistency when a
future policymaker has both the means and the motivation to break the commitment. A
timeconsistent policy meets the long-run policy goal but does not make people happy in the
short run. The Government Budget Constraint When government finds it difficult to raise
adequate resources to finance its increased expenditure fully through normal taxes, it faces a
resource constraint resulting in budget deficit which in recent years is also called fiscal deficit.
Thus, government budget constraint is reflected in budget deficit.The government budget
constraint is an accounting identity linking the monetary authority's choices of money growth
or nominal interest rate and the fiscal authority's choices of spending, taxation, and borrowing
at a point in time.

The Government Budget Constraint in a closed economy as reflected in budget deficit can be
expressed as:

Budget deficit = Printed Money + Sale of Bonds Similarly, the Government Budget
Constraint in an open economy as reflected in budget deficit can be expressed as: Budget
deficit = Printed Money + Domestic borrowing through Sale of Bonds +(Use of Foreign
exchange Reserve + Foreign Borrowing)

Fiscal and monetary policy are two powerful tools used by governments and central banks to
manage and stabilize the economy. They aim to achieve specific economic goals such as
controlling inflation, reducing unemployment, and promoting economic growth.

Fiscal Policy:

Fiscal policy refers to the government's use of taxation and spending to influence the economy.
It involves decisions regarding government spending on goods and services, as well as the
collection of taxes from individuals and businesses. Here are the key components of fiscal
policy:

Government Spending: Governments can stimulate economic activity by increasing spending

on infrastructure projects, education, healthcare, and other public services. This injection of
funds into the economy creates jobs, boosts demand for goods and services, and stimulates
economic growth.

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Taxation: Taxation is another tool used by governments to regulate economic activity. By
adjusting tax rates, governments can influence disposable income, consumption, and
investment. For instance, cutting taxes can provide individuals and businesses with more
money to spend and invest, thereby stimulating economic activity.

Budget Deficits and Surpluses: Fiscal policy can result in budget deficits (when government
spending exceeds revenue) or surpluses (when revenue exceeds spending). Deficit spending is
often used during economic downturns to stimulate growth, while surpluses can be used to pay
down debt or save for future economic challenges.

Monetary Policy:

Monetary policy involves the management of money supply and interest rates by a central bank
to achieve economic objectives. Central banks, such as the Federal Reserve in the United States
or the European Central Bank in the Eurozone, implement monetary policy. Key components
of monetary policy include:

Interest Rates: Central banks adjust interest rates to influence borrowing, spending, and
investment decisions. Lowering interest rates encourages borrowing and spending by making
it cheaper to borrow money, which stimulates economic activity. Conversely, raising interest
rates can dampen inflationary pressures by reducing borrowing and spending.

Money Supply: Central banks control the money supply through open market operations,
reserve requirements, and discount rates. By buying or selling government securities in the
open market, central banks can inject or withdraw money from the economy, thereby
influencing interest rates and overall economic activity.

Inflation Targeting: Many central banks employ inflation targeting as a monetary policy
framework. They set a target inflation rate and adjust monetary policy instruments to achieve
it. Controlling inflation is crucial for maintaining price stability and fostering sustainable
economic growth.

Both fiscal and monetary policy play complementary roles in shaping the economy. Fiscal
policy focuses on government spending and taxation, while monetary policy primarily deals

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with money supply and interest rates. Effective coordination between fiscal and monetary
authorities is essential for achieving macroeconomic stability and promoting long-term
prosperity.

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 Topic 4: Markets

Markets are the cornerstone of economic activity, serving as the mechanisms through which
goods and services are exchanged, prices are determined, and resources are allocated. In
economics, the study of markets provides insights into how supply and demand interact to
shape economic outcomes, efficiency, and welfare. This comprehensive exploration of markets
encompasses various characteristics, types, and functions that are essential for understanding
the dynamics of economic systems.

Introduction to Markets

A market is a system or arrangement where buyers and sellers interact to exchange goods,
services, or resources. Markets can exist for both tangible products such as food, clothing, and
automobiles, as well as intangible services like education, healthcare, and financial services.
Key characteristics of markets include:

Buyers and Sellers: Markets involve individuals, households, firms, or institutions acting as
buyers and sellers who engage in voluntary transactions to buy and sell goods and services.

Price Mechanism: Prices serve as signals that convey information about supply and demand
conditions in the market. The interaction of buyers and sellers determines equilibrium prices
and quantities.

Competition: Competition among buyers and sellers ensures that prices reflect underlying
supply and demand forces and drives efficiency in resource allocation.

Market Structure: Markets can exhibit different structures, ranging from perfectly
competitive markets with many small firms to monopolistic markets with a single dominant
seller.

Market Clearing: In competitive markets, prices adjust to balance supply and demand, leading
to the clearing of markets where the quantity supplied equals the quantity demanded.

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Role of Institutions: Institutions such as property rights, contract enforcement, and regulatory
frameworks play a crucial role in facilitating market transactions and maintaining market
efficiency.

Types of Markets

Markets can be classified based on various criteria, including the nature of the goods or services
being exchanged, the number of buyers and sellers, and the degree of competition. Some
common types of markets include:

Perfectly Competitive Markets: Characterized by many small firms producing identical

products, perfect competition ensures that no single firm has the power to influence market
prices. Prices are determined by the forces of supply and demand, and firms are price takers.

Monopoly Markets: Monopoly markets feature a single seller or producer that controls the
entire market for a particular product or service. Monopolies can restrict output, raise prices,
and earn economic profits due to barriers to entry or government regulations.

Oligopoly Markets: Oligopoly markets are dominated by a few large firms that account for a
significant share of industry output. Firms in oligopolistic markets may engage in strategic
behavior, such as price collusion or non-price competition, to gain market power.

Monopolistic Competition: Monopolistic competition exists when many firms produce

differentiated products that are similar but not identical. Each firm has some degree of market
power and can set prices above marginal cost, leading to excess capacity and product
differentiation.

Labor Markets: Labor markets involve the exchange of labor services between workers and
employers. Wages are determined by the demand for and supply of labor, influenced by factors
such as skills, education, experience, and labor market institutions.

Financial Markets: Financial markets facilitate the exchange of financial assets such as stocks,
bonds, currencies, and derivatives. Financial markets play a critical role in allocating capital,
managing risk, and facilitating investment and economic growth.

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Functions of Markets

Markets perform several essential functions that contribute to economic efficiency, growth, and
welfare. These functions include:

Allocation of Resources: Markets allocate scarce resources among competing uses based on
consumer preferences and producer costs. Prices serve as signals that guide resource allocation
decisions, directing resources to their most valued uses.

Price Determination: Markets determine prices through the interaction of supply and demand
forces. Prices reflect underlying economic conditions, scarcity, utility, production costs, and
market equilibrium.

Efficiency: Competitive markets promote allocative efficiency, where resources are allocated
to maximize total societal welfare or utility. In competitive equilibrium, the marginal benefit
of consumption equals the marginal cost of production, leading to Pareto efficiency.

Innovation and Entrepreneurship: Markets provide incentives for innovation,

entrepreneurship, and technological advancement by rewarding firms that introduce new
products, processes, or business models with economic profits.

Income Distribution: Markets influence income distribution by determining wages, salaries,

rents, and profits earned by factors of production such as labor, land, and capital. Market
outcomes can lead to income inequality or redistribution through government intervention.

Integration and Globalization: Markets facilitate trade, specialization, and economic

integration at the national and international levels. Global markets allow countries to benefit
from comparative advantages, expand markets for goods and services, and promote economic
interdependence.

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Market Failures and Government Intervention

While markets are generally efficient in allocating resources and promoting economic welfare,
they can fail to achieve desirable outcomes under certain conditions. Market failures occur
when the allocation of resources by markets leads to inefficiencies, inequities, or adverse
effects on society. Common causes of market failures include:

Externalities: Externalities arise when the actions of buyers or sellers impose costs or benefits
on third parties not involved in the transaction. Positive externalities, such as education or
vaccinations, may be underprovided by markets, while negative externalities, such as pollution
or congestion, may be overproduced.

Public Goods: Public goods are non-excludable and non-rivalrous, meaning that consumption
by one individual does not diminish the availability of the good for others. Public goods may
be underprovided by markets due to the free-rider problem, where individuals benefit from the
good without contributing to its provision.

Market Power: Monopolies, oligopolies, and monopolistic competition can lead to market
power, allowing firms to restrict output, raise prices, and reduce consumer welfare. Antitrust
laws and regulations may be used to prevent or mitigate market power and promote
competition.

Incomplete Information: Asymmetric information between buyers and sellers can lead to
market failures such as adverse selection and moral hazard. Government regulations, consumer
protection laws, and disclosure requirements may be implemented to address information
asymmetry and ensure market efficiency.

Income Inequality: Markets may lead to unequal distribution of income and wealth, resulting
in social and economic disparities. Government interventions such as progressive taxation,
social welfare programs, and education and training initiatives may be used to address income
inequality and promote social cohesion.

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Markets are fundamental institutions that play a central role in economic systems, facilitating
the exchange of goods, services, and resources, determining prices, and allocating scarce
resources efficiently. Understanding the characteristics, types, functions, and dynamics of
markets is essential for analyzing economic behavior, evaluating public policies, and promoting
economic welfare and prosperity. While markets generally lead to desirable outcomes,
government intervention may be necessary to address market failures, ensure equitable
distribution of resources, and promote social welfare and economic development.

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 Topic 5: Theory of Production

Production theory is the study of production, or the economic process of producing outputs
from the inputs. Production uses resources to create a good or service that are suitable for use
or exchange in a market economy. This can include manufacturing, storing, shipping, and
packaging. Some economists define production broadly as all economic activity other than
consumption. They see every commercial activity other than the final purchase as some form
of production.

Production is a process, and as such it occurs through time and space. Because it is a flow
concept, production is measured as a “rate of output per period of time”. There are three aspects
to production processes:

1. The quantity of the good or service produced.

2. The form of the good or service created.

3. The temporal and spatial distribution of the good or service produced.

A production process can be defined as any activity that increases the similarity between the
pattern of demand for goods and services, and the quantity, form, shape, size, length and
distribution of these goods and services available to the market place.

Production is a process of combining various material inputs and immaterial inputs (plans,
know-how) in order to make something for consumption (the output). It is the act of creating
output, a good or service which has value and contributes to the utility of individuals.

Production Function

•In economics, a production function relates physical output of a production process to physical
inputs or factors of production.

•It is a mathematical function that relates the maximum amount of output that can be obtained
from a given number of inputs - generally capital and labor.

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•The production function, therefore, describes a boundary or frontier representing the limit of
output obtainable from each feasible combination of inputs.

•Firms use the production function to determine how much output they should produce given
the price of a good, and what combination of inputs they should use to produce given the price
of capital and labor.

•Increasing marginal costs can be identified using the production function. If a firm has a
production function Q=F(K,L) (that is, the quantity of output (Q) is some function of capital
(K) and labor (L)), then if 2Q<F(2K,2L), the production function has increasing marginal costs
and diminishing returns to scale. Similarly, if 2Q>F(2K,2L), there are increasing returns to
scale, and if 2Q=F(2K,2L), there are constant returns to scale.

. Examples of Common Production Functions

•One very simple example of a production function might be Q=K+L, where Q is the quantity
of output, K is the amount of capital, and L is the amount of labor used in production. This
production function says that a firm can produce one unit of output for every unit of capital or
labor it employs. From this production function we can see that this industry has constant
returns to scale - that is, the amount of output will increase proportionally to any increase in
the number of inputs.

•Another common production function is the Cobb-Douglas production function. One example
of this type of function is Q=K0.5L0.5. This describes a firm that requires the least total number
of inputs when the combination of inputs is relatively equal. For example, the firm could
produce 25 units of output by using 25 units of capital and 25 of labor, or it could produce the
same 25 units of output with 125 units of labor and only one unit of capital.

•Finally, the Leontief production function applies to situations in which inputs must be used in
fixed proportions; starting from those proportions, if usage of one input is increased without
another being increased, output will not change. This production function is given by
Q=Min(K, L). For example, a firm with five employees will produce five units of output as
long as it has at least five units of capital.

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Factors of production

•Economic resources are the goods or services available to individuals and businesses used to
produce valuable consumer products.

•The classic economic resources include land, labor and capital. Entrepreneurship is also
considered an economic resource because individuals are responsible for creating businesses
and moving economic resources in the business environment.

•These economic resources are also called the factors of production. The factors of production
describe the function that each resource performs in the business environment.

Land

•Land is the economic resource encompassing natural resources found within the economy.

•This resource includes timber, land, fisheries, farms and other similar natural resources.

•Land is usually a limited resource for many economies. Although some natural resources, such
as timber, food and animals, are renewable, the physical land is usually a fixed resource.

•Nations must carefully use their land resource by creating a mix of natural and industrial uses.

•Using land for industrial purposes allows nations to improve the production processes for
turning natural resources into consumer goods.

Labor

•Labor represents the human capital available to transform raw or national resources into
consumer goods.

•Human capital includes all individuals capable of working in the economy and providing
various services to other individuals or businesses.

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•This factor of production is a flexible resource as workers can be allocated to different areas
of the economy for producing consumer goods or services.

•Human capital can also be improved through training or educating workers to complete
technical functions or business tasks when working with other economic resources.

Capital

•Capital has two economic definitions as a factor of production.

•Capital can represent the monetary resources companies use to purchase natural resources,
land and other capital goods.

•Monetary resources flow through a economy as individuals buy and sell resources to
individuals and businesses.

•Capital also represents the major physical assets individuals and companies use when
producing goods or services. These assets include buildings, production facilities, equipment,
vehicles and other similar items.

•Individuals may create their own capital production resources, purchase them from another
individual or business or lease them for a specific amount of time from individuals or other
businesses.

Entrepreneurship

•Entrepreneurship is considered a factor of production because economic resources can exist in

an economy and not be transformed into consumer goods.

•Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk
involved with transforming economic resources into consumer products.

•Entrepreneurship is also considered a factor of production since someone must complete the
managerial functions of gathering, allocating and distributing economic resources or consumer
products to individuals and other businesses in the economy.

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Three Stages of Production Stage-I: Increasing Returns

•In stage I the average product reaches the maximum and equals the marginal product when 4
workers are employed, as shown in the Table Above.

•This stage is shown in the figure from the origin to point E where the MP curve reaches its
maximum and the AP curve is still rising. In this stage, the TP curve also increases rapidly.

•Thus this stage relates to increasing returns.

•Here land is too much in relation to the workers employed. It is, therefore, profitable for a
producer to increase more workers to produce more and more output.

•It becomes cheaper to produce the additional output. Consequently, it would be foolish to stop
producing more in this stage. Thus, the producer will always expand through this stage I.

Causes of Increasing Returns

1.The main reason for increasing returns in the first stage is that in the beginning the fixed
factors are larger in quantity than the variable factor. When more units of the variable factor
are applied to a fixed factor, the fixed factor is used more intensively and production increases
rapidly.

2.In the beginning, the fixed factor cannot be put to the maximum use due to the
nonapplicability of sufficient units of the variable factor. But when units of the variable factor
are applied in sufficient quantities, division of labor and specialization lead to per unit increase
in production and the law of increasing returns operate.

3.Another reason for increasing returns is that the fixed factors are indivisible which means that
they must be used in a fixed minimum size. When more units of the variable factor are applied
on such a fixed factor, production increases more than proportionately. It points towards the
law of increasing returns.

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Stage-II: Diminishing Returns

•It is the most important stage of production. Stage II starts from point E where the MP curve
intersects the AP curve which is at the maximum.

•Then both continue to decline with AP above MP and the TP curve begins to increase at a
decreasing rate till it reaches point C.

•At this point the MP curve becomes negative when the TP curve begins to decline, table above
shows this stage when the workers are increased from 4 to 7 to cultivate the given land.

•In figure, it lies between BE and CF. Here land is scarce and is used intensively. More and
more workers are employed in order to have larger output.

•So in this stage the total product increases at a diminishing rate and the average and marginal
product decline.

•This is the only stage in which production is feasible and profitable because in this stage the
marginal productivity of labor, though positive, is diminishing but is non-negative.

•Hence it is not correct to say that the law of variable proportions is another name for the law
of diminishing returns. In fact, the law of diminishing returns is only one phase of the law of
variable proportions.

•The law of diminishing returns in this sense has been defined by Prof. Benham thus: “As the
proportion of one factor in a combination of factors is increased, after a point, the average and
marginal product of that factor will diminish.”

Causes of Diminishing Returns

•But the law of diminishing returns is not applicable to agriculture only, rather it is applicable
universally.

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•It is called the law in its general form, which states that if the proportion in which the factors
of production are combined, is disturbed, the average and marginal product of that factor will
diminish.

•The distortion in the combination of factors may be either due to the increase in the proportion
of one factor in relation to others or due to the scarcity of one in relation to other factors.

•In either case, diseconomies of production set in, which raise costs and reduce output.

•For instance, if plant is expanded by installing more machines, it may become unwieldy.
Entrepreneurial control and supervision become lax, and diminishing returns set in. Or, there
may arise scarcity of trained labor or raw material that leads to diminution in output.

•In fact, it is the scarcity of one factor in relation to other factors which is the root cause of the
law of diminishing returns. The element of scarcity is found in factors because they cannot be
substituted for one another.

•According to Wicksteed, the law of diminishing returns “is as universal as the law of life itself.’
The universal applicability of this law has taken economics to the realm of science.

Stage-III: Negative Marginal Returns

•Production cannot take place in stage III either. For in this stage, total product starts declining
and the marginal product becomes negative.

•The employment of the 8th worker actually causes a decrease in total output from 60 to 56
units and makes the marginal product minus 4.

•In the figure, this stage starts from the dotted line CF where the MP curve is below the A’axis.
Here the workers are too many in relation to the available land, making it absolutely impossible
to cultivate it.

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The Best Stage

•In stage I, when production takes place to the left of point E, the fixed factor is excess in
relation to the variable factors which cannot be used optimally. To the right of point F, the
variable input is used excessively in Stage III. Therefore, no producer will produce in this stage
because the marginal production is negative.

•Thus, the first and third stages are economically not feasible.
•So, production will always take place in the second stage in which total output of the firm
increases at a diminishing rate and MP and AP are the maximum, then they start decreasing and
production is optimum. This is the optimum and best stage of production.

The Law of Returns to Scale

•The law of returns to scale describes the relationship between outputs and scale of inputs in
the long-run when all the inputs are increased in the same proportion.

•In the words of Prof. Roger Miller, “Returns to scale refer to the relationship between changes
in output and proportionate changes in all factors of production.

•To meet a long-run change in demand, the firm increases its scale of production by using more
space, more machines and labors in the factory’.

Assumptions

1. All factors (inputs) are variable but enterprise is fixed.

2. A worker works with given tools and implements.

3. Technological changes are absent.

4. There is perfect competition.

5. The product is measured in quantities.

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Example

Given these assumptions, when all inputs are increased in unchanged proportions and the scale
of production is expanded, the effect on output shows three stages: increasing returns to scale,
constant returns to scale and diminishing returns to scale. They are explained with the help of
Table and Figure below.

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 Topic 6: Public Finance

The State in modern times is called a welfare State. The activities of such a modern welfare
State have vastly increased. For a smooth performance of these functions the State nee&
finance. Thus, public finance means the finances of public bodies—national, State or local—
for the performance of their functions. The term 'finance' may also refer to financial
management and administration. Public finance thus means the administration of the financial
operations of the public authorities. It refers to that branch of Economics which deal with the
income and expenditure of public bodies and the principles, problems and policies relating to
these matters.

Definition
Carl Plehn defines public finance as. "The science which deals with the activity of statesman
in obtaining and applying the material means necessary for fulfilling the proper functions of
the State."

Scope of Public Finance

1. Public Revenues – In his division we study all those sources from which the government
derives its revenues. An extensive study of the principles of taxation is an integral part of this
branch. Along with this, we also study in this branch the problem of the incidence of taxation-
2. Public Expenditure – Public expenditure is the beginning and end of the collection of
revenues by the government. As pointed out by Plehn, "Public expenditure is the end and aim
of collection of revenues and of other financial activities of the statesman". Under public
expenditure we study its classification, the canons or principles which govern it and its effects
on production, employment, income distribution, stability and growth. We also study the
reasons for increase in public expenditure and changes in the pattern.

3. Public Debt – When public revenue falls short of public expenditure, the government
borrows from the public to meet the gap. This is public debt. Under public debt; we study the

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reasons, methods and sources of public debt, its effects on production, consumption, income
distribution and economy, the burden of public debt and the methods of debt redemption

4. Financial Administration – The aim of financial administration is to control processes

and operations of public revenue, public expenditure and public debt. The scope of financial
administration includes the collection, custody and disbursement of public money; the
coordination of expenditure according to a well-formulated plan; the management of public
debt; and the general control of the financial operations of the state. It also includes the Nature
of Public Finance preparation of the budget; its execution and above all auditing the finances
of the state.

Nature of Public Finance

1. It is a Social Science – Public finance is a social science which is concerned with the
problems of raising of funds and their allocation for the collective satisfaction of wants. Its
methods of study are based both on the study of the principles and theories or laws of public
finance and on a descriptive and statistical study of the actual operations of government
finances. Its principles are in the nature of generalizations which state the cause-and-effect
relationships of different variables like public revenue, expenditure, debt and financial
administration. These also form the subject matter of public finance.

2. It is an Art – Public finance is also an art. It is concerned with fiscal policies which
influence economic policies and economic structure of the country. All governments aim at
bringing social justice through an equitable financial system.

Importance of Public Finance

1. Increasing the growth rate of Economy – The role of public expenditure in economic
development lies in increasing the growth rate of the economy, providing more employment
opportunities, raising incomes and standard of living, reducing inequalities of income and
wealth, encouraging private initiative and enterprise and bringing about regional balance in the
economy. All these are achieved by spending on public works, agriculture: industry, transport

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and communications, power, financial and banking institutions, social services etc. The
government is able to increase public expenditure through a budget deficit.

2. Emergence of Social Services – The importance of public finance as also increased

due to emergence of social services which can be performed more conveniently, efficiently and
also at the minimum cost as against individual. Such services are education, health, social
security and protection from certain uncertainties. The need for such social services is
increasing day by day and with them is increasing the importance of public finance.

3. Reduction in Economic Inequalities – Public finance can play a vital role in reducing
economic inequalities which is the source of dissatisfaction, class-struggles, poverty etc. The
state can levy heavy taxes on richer sections of the society and thereby spend the income so
received on providing food, cheap housing, free medical aid etc. for the poorer sections of the
society. Similarly, heavy taxes can be imposed on the use of harmful commodities, such as
harmful drugs, wine, opium, hashish etc.

4. Increases Employment – Public finance can play vital role in increasing employment
which is the burning problem of almost all the countries of the world, The Governments these
days establish, give grants, subsidies, grant exemption from excise duty, sales tax etc. to
employment-oriented cottage and small-scale industries. Unbalanced budget is also an
indispensable measure of increasing volume of employment during depression.

5. Capital Formation – The economic development, as is well known, depends upon the
rate of capital-formation in the country. Public finance can play a vital role in increasing the
rate of capital-formation in the economy. It can be managed in such a manner as to step up the
rate of saving and investment in the economy. For example, the tax system can be so managed
as to discourage the consumption of non-essential goods and thereby release the resources for
being invested in more productive industries. Further, the tax system can be employed to
increase the rate of private saving which in turn, can be used as the basis for an increase in
public investment.

6. Industrial Development – The governments these days give subsidies and grants to
different industries to enable them to increase the production of essential goods in the country.

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These subsidies and grants have special place in the government expenditure of
underdeveloped and backward countries.

Differences or Dissimilarities between public and private finance

The following are the main points of differences or dissimilarities between public and private
finance:

1. Adjustment between Income and Expenditure– An individual determines his

expenditure on the basis of his income. He prepares his family budget on his expected income
during the month. On the other hand, the government first estimates about its expenditure and
then finds out means to raise the necessary income.

2. Elasticity of Finance – Public Finance is more elastic than private finance. There is not
much scope for changes in private finance while drastic changes can be made in government
finance. For example, a private individual cannot affect any special increase in his income. As
against this the government can increase its income by imposing fresh taxes on the people.

3. Differences in Objectives – There are a fundamental difference in the objective of

private and public finance. The motive of private expenditure is personal benefit whereas the
objective of public expenditure is social benefit. An individual always tries to save and a firm
to earn profit. But there are no such considerations on the part of the government, except the
public welfare. However, there are some public enterprises which are run on profits that are
utilised for public welfare.

4. Nature of Expenditure – There are differences in the nature of expenditure between the
two". An Individual's expenditure is governed by his habits, customs, fashions etc on the other
hand. The government expenditure depends on its economic and social policies, like removing
unemployment and poverty, reducing income inequalities, providing' infrastructure facilities,
etc.

5. Compulsion – There is compulsion in public finance. People have to pay taxes. If they
do not pay, they are punished by fine and imprisonment. BA an individual or firm cannot force
anybody to pay him money. He can file a suit in the court. But even then he may not receive

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his money back. The same is the case with loans. The government can force the people to lend
it during war or emergency. But a individual cannot compel any person to lend him money.

6. Law of Equi-marginal Utility – The private individual spends his me on various items
in such a manner as to secure equal marginal utilities from them. It is only by equalizing the
various marginal utilities that he can secure maximum utility out of his expenditure. The
government on the contrary, does not give as much importance to this law as a private
individual does. Modern governments sometimes incur certain types of expenditure from
which they do not derive any advantage, but they o incur this expenditure to satisfy certain
sections of the community.

7. Present Vs Future – An individual is more concerned with his present needs and tries
to satisfy them. Life being uncertain and short, he has his immediate gain or profit in view. On
the other hand, government is a permanent organisation. Only the ruling party changes it is
concerned not only with the welfare of present generation but also, I with future generations.
It therefore, undertakes and spends on those activities which also benefit future generations.

8. Nature of the Budget – A surplus budget is always good for a private individual. Bin
a surplus budget may not be good for the government. It implies two things: (i) The government
is levying more taxes on the people than is necessary, (ii) The government is not spending as
much on the welfare of the public as it should. Keynes supported a deficit budget to meet the
situation created by depression. Further, the government budget is passed by the parliament.
But the budget of an individual or firm is a private affair without any controlling authority.

9. Nature of Borrowing – In the case of an individual, there can no internal borrowing".

An individual cannot borrow from himself. He can borrow only from an external agency. The
State, however, can borrow both from internal as well as external sources. It borrows not only
from its own citizens, but also from foreigners.

Budgetary activities of the government results in transfer of purchasing power from some
individuals to others. Taxation causes transfer of purchasing power from tax payers to the
public authorities, while public expenditure results in transfer back from the public authorities
to some individuals, therefore financial operations of the government cause ‘Sacrifice or
Disutility’ on one hand and ‘Benefits or Utility’ on the other. This results in changes in pattern

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of production, consumption & distribution of income and wealth. So it is important to know
whether those changes are socially advantageous or not. If they are socially advantageous, then
the financial operations are justified otherwise not. According to Hugh Dalton, “The best
system of public finance is that which secures the maximum social advantages from the
operations which it conducts.”

Public finance is a complex and dynamic field that examines the role of government in the
economy, the mechanisms of revenue generation and expenditure allocation, and the
implications for economic and social outcomes. By understanding the principles and practices
of public finance, policymakers, economists, and citizens can make informed decisions about
fiscal policy, public investment priorities, and sustainable development strategies to promote
inclusive growth, prosperity, and well-being.

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